Investors today have many options to invest their money and build a portfolio that will help them in their retirement or on any rainy day. Investors can choose an investment option based on many factors. One of the main factors is the risk reward ratio where the investors can assess the returns against the risk of investment. This is particularly helpful to risk-averse investors who want to limit their exposure yet earn decent returns that will help them grow their wealth.
For long-term and new investors, a passive investment strategy is ideal. This strategy allows the investors to invest in dynamic investment products that provide higher investment returns than traditional investment products that may be relatively risk-free but also provide lower returns.
Given below are a few examples of passive investment instruments:
What is meant by Passive Investment strategy?
Investments are classified in mainly two broad categories namely active investment strategy and passive investment strategy. Active investment strategy requires an aggressive approach with investments, the returns are higher but the risk is higher as well. The most common example of active investment strategy is mutual funds.
Passive investment strategy, on the other hand, is relatively easy-to-monitor strategy. Investment options under this strategy aim to provide returns in line with its benchmark. These investment products usually follow an underlying index and try to match its performance. Some of the common examples of passive investment strategies are ETFs, Index funds, etc.
Benefits of Passive Investments
Passive investments provide many benefits to investors which help them gradually build their corpus fund. Some of the prime benefits of passive instruments are mentioned below.
Reduced costs
The expense ratio for passive investment products is lower as compared to active investment products. The prime expense for any investment is the fund manager fees which are reduced in the case of passive investment instruments.
Simplicity of investment
Passive investment products simply track their underlying index for their performance i.e., they try to match it to the closest level. This tracking is subject to certain errors known as tracking errors. It is the fund manager’s job to reduce such errors to a minimum possible extent and thereby increase the returns. The investment can be made through the fund house or by the investors themselves as per the fund guidelines.
Reduced taxes
The taxability of passive investment instruments is lower as compared to active investment products. This is on account of holding the investments for a longer period which may result in reduced capital gains.
Less influence of fund managers
Fund managers do not have an active role in managing the passive funds as compared to actively managed funds. The bias of the fund managers will therefore not affect the performance of the fund.
Better transparency
Passively managed funds provide better transparency regarding the underlying assets that form the fund. These assets or securities are generally in the same weightage as that of the index.
Examples of passive investment instruments
After discussing the above details of passive investment instruments, let us now take a close look at some of its examples.
ETFs
ETFs are one of the most common examples of passive investment instruments. Given below are the details of this fund.
Meaning
ETFs are the Exchange Traded funds that follow an underlying index for their performance. These funds are also a basket of funds like mutual funds but can be traded in the open market like individual stocks.
Advantages of investing in ETFs
Some of the main advantages of ETFs are mentioned below.
- Liquidity and mode of trade
The prime advantage of ETFs is their liquidity. ETFs can be traded like any other individual stocks in the open market. This unique advantage gives them an edge over other similar products and helps them in being quite liquid.
- Expense ratio
The expense ratio of ETFs is lower when compared to mutual funds or other similar investment products.
Disadvantages of investing in ETFs
Some of the main disadvantages of ETFs are discussed below.
- Demat account and trading account needed
Investors are mandatorily required to have a Demat account as well as a trading account to trade in ETFs. This makes it tedious for the investors when compared to investment in mutual funds or other actively managed funds.
- Lower returns
The returns generated through ETFs may be lower in comparison to returns generated through actively managed mutual funds.
Index funds
Meaning
Index funds are similar to ETFs as they also track an underlying index for their performance. Some details of these funds are mentioned below.
Advantages of investing in index funds
Some of the major advantages of index funds are discussed hereunder.
- Reduced risk
The risk of investing in index funds is lower as compared to mutual funds as they simply track the index.
- Cost of investment
The cost of investment or the expense ratio in index funds is also lower than that of mutual funds as they are considered to be passively managed funds.
- Simplicity of investment
The investors can simply contact the fund manager to start an investment in index funds or can directly invest in these funds if the fund guidelines permit.
Disadvantages of investing in index funds
Some of the main disadvantages of investing in index funds are detailed below.
- Reduced returns
The returns on index funds are limited as the fund does not outperform its index at any point in time. The agenda is to replicate the returns and not outperform them as is the case with any actively managed fund.
- No control over investment
Investors have no control over their investment portfolios. The composition of the fund is based on the index it tracks where the securities are also held in the same weightage as the index.
- Tracking errors
Tracking errors are part of any index funds. The fund manager can strive to reduce errors to the maximum extent but cannot eliminate them completely.
Fund of funds
Fund of funds is another passive fund that belongs to this category. The details of these funds are mentioned hereunder.
Meaning
Fund of funds is a type of mutual fund. These funds invest in other mutual funds instead of individuals securities. The fund manager can invest in funds from the same fund house or of other fund houses as per their investment objectives.
Advantages of investing in fund of funds
- Diversification
Diversification is one of the prime benefits of mutual funds. This benefit gets enhanced in a fund of funds due to their investment in multiple mutual funds.
- Fund manager’s expertise
Investors get the benefit of the expertise of multiple fund managers that strive to increase the investor’s wealth.
- Lower cost of investing in mutual funds
Investors get the benefit of exposure to multiple securities, sectors, industries by investing in fund of funds. The cost of investment in such assets otherwise would have been huge if the investor would have invested in them separately. By investing in fund of funds, these assets can be accessed even through limited resources.
Disadvantages of investing in fund of funds
After discussing the advantages of fund of funds, let us now discuss the disadvantages.
- Higher expense ratio
Although funds of funds are passive funds, the expense ratio of such funds is higher than other investment products of similar nature like ETFs. This may lower the net returns of the investors.
- Lower liquidity
Fund of funds provide limited liquidity as the chances of redemption of units are lower.
- Taxation
Taxation on fund of funds is similar to any other mutual funds. The rate of taxation depends on the asset orientation of the fund.
Smart Beta Funds
Smart-beta funds are an extension of ETFs. These funds fill the gap between passively managed funds and actively managed funds. The details of these funds are given below.
Meaning
Smart-beta funds also track an index for their performance but they are curated based on certain specific factors that help in generating higher returns while maintaining lower costs and reduced risks.
Advantages of investing in smart-beta funds
Some of the major advantages of smart-beta funds are listed below.
- One of the main advantages of smart beta funds are the increased returns as compared to regular ETFs
- Diversification like any other ETF is another advantage of smart beta funds.
- Reduced risk of investment like any other ETF.
- Disadvantages of investing in smart beta funds
Disadvantages of smart-beta funds
- Since smart beta funds are relatively newer to the Indian markets, they have reduced liquidity on account of lower trading volumes.
- The cost of investment or the expense ratio of these funds is higher than traditional ETFs.
Conclusion
There are many investment options that can be accessed by investors when it comes to passive investment instruments. These instruments cater to the risk profile of risk-averse investors while providing them with decent returns. These instruments provide more investment options to investors with low-risk appetites who would otherwise have been stuck to traditional low-risk low return products like PPF, NSC, life insurance, etc. only.
FAQs
1. Is passive investment strategy beneficial to investors with a low investment horizon?
A. Passive investment strategy requires the investors to be invested for a longer period of time. Short term investments in passive instruments will not help such investors increase their wealth substantially.
2. Are passive investment instruments suitable for beginners?
A. Yes. Passive investment instruments are ideal for new investors as it limits their exposure and provides them decent returns at lower costs.
3. What are the differences between actively managed funds and passively managed funds?
A. Actively managed funds and passively managed funds are part of two completely different investment strategies. Some of the basic differences between the two are highlighted below.
| Actively managed funds | Passively managed funds |
| These funds require the active involvement of the fund manager to select the securities of the fund that will help ion generating higher returns | Passive funds do not require the active involvement of the fund managers. The fund simply tracks the underlying index for its performance. |
| The expense ratio of these funds is quite higher. | The expense ratio of these funds is lower than actively managed funds |
| Actively managed funds have the potential to provide higher returns to the investors. | Passively managed funds do not outperform the underlying index but simply try to match it with minimum possible errors (tracking errors) |
| The risk in actively managed funds is higher. It is a high-risk high return scenario | The risk in passively managed funds is lower. |
